Ohio Wesleyan University Goran Skosples 8. Economic Fluctuations

difference between short run & long run the IS curve, and its relation to the Keynesian Cross the Loanable Funds model the LM curve, and its relation to the Theory of Liquidity Preference how the IS-LM model determines income and the interest rate in the short run when P is fixed

Growth rates of real GDP, consumption Average growth rate

Growth rates of real GDP, consump., investment

Unemployment

Index of Leading Economic Indicators Published monthly by the Conference Board. Aims to forecast changes in economic activity 6-9 months into the future. Used in planning by businesses and govt, despite not being a perfect predictor. 5

Components of the LEI index Average workweek in manufacturing Initial weekly claims for unempl. insurance New orders for consumer goods and materials New orders, nondefense capital goods Vendor performance New building permits issued Index of stock prices M2 Yield spread (10year - 3month) on Treasuries Index of consumer expectations 6

Index of Leading Economic Indicators, 1970-2012 2004 = 100 The index turns downward a few months to a year before each recession. It also turns upward just prior to the end of almost every recession. Source: Conference Board. http://www.conference-board.org Source: Conference Board

Index of Leading Economic Indicators

The economy behaves much differently when prices are sticky. Time horizons Long run: Prices are flexible, respond to changes in supply or demand Short run: many prices are “sticky” at some predetermined level The economy behaves much differently when prices are sticky.

In Classical Macroeconomic Theory, (what we studied in chapters 3-8) Output is determined by the supply side: supplies of capital, labor technology Changes in demand for goods & services (C, I, G ) only affect _______, not ___________. Complete price flexibility is a crucial assumption, so classical theory applies in the _________.

When prices are sticky …output and employment also depend on demand for goods & services, which is affected by fiscal policy (G and T ) monetary policy (M ) other factors, like exogenous changes in C or I.

The model of aggregate demand and supply the paradigm that most mainstream economists & policymakers use to think about economic fluctuations and policies to stabilize the economy shows how the price level and aggregate output are determined shows how the economy’s behavior is different in the short run and long run

The Big Picture Keynesian Cross IS curve IS-LM model Explanation of short-run fluctuations Theory of Liquidity Preference LM curve Agg. demand curve Model of Agg. Demand and Agg. Supply Agg. supply curve

The Keynesian Cross A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure Difference between actual & planned expenditure: unplanned inventory investment

Elements of the Keynesian Cross consumption function: gov’t policy variables: for now, investment is exogenous: planned expenditure: Equilibrium condition:

Graphing planned expenditure income, output, Y

Graphing the equilibrium condition planned expenditure income, output, Y

The equilibrium value of income E =Y E =C +I +G income, output, Y E planned expenditure

An increase in government purchases Y E E =Y At Y1, there is now an ____________ in inventory… E =C +I +G1 …so firms ______ output, and income _____ toward a new equilibrium E1 = Y1

Solving for Y equilibrium condition in changes because I exogenous because C = MPC Y Collect terms with Y on the left side of the equals sign: Finally, solve for Y :

The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the gov’t purchases multiplier equals Example: If MPC = 0.8, then An increase in G causes income to increase __ times as much! Why DY/DG > 1? DG = DY

An increase in taxes E Y E =C1 +I +G E1 = Y1 E =Y Initially, the tax increase ______ consumption, and therefore E: E =C1 +I +G …so firms ______ output, and income _____ toward a new equilibrium E1 = Y1

Solving for Y eq’m condition in changes I and G exogenous Final result:

The Tax Multiplier def: the change in income resulting from a $1 increase in T : If MPC = 0.8, then the tax multiplier equals

Exercise: Use a graph of the Keynesian Cross to show the impact of a decrease in investment on the equilibrium level of income/output. E =Y E =C +I1 +G income, output, Y E planned expenditure

Results In this simple model, the change in GDP is always _________ than the change in investment. Thus, relatively small fluctuations in I can lead to __________ fluctuations in Y. Intuition? Suppose firms get pessimistic (due to “animal spirits”): The initial drop in I reduces Y _________, and some workers have lost jobs Remaining workers cut their consumption (C ) in response to bad conditions This causes firms to cut output further (in a self-fulfilling downward spiral)

The IS-LM Model: Standard Keynesian Framework 4 equations: 1. Y = C + I + G 2. C = C (Y – T ) 3. I = I (r ) 4. M /P = L (r, Y ) Strategy: reduce this 4 equation system to two equations so we can plot this is the point of the IS-LM curves we can then do simple policy experiments

The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium, i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is:

Deriving the IS curve (Keynesian cross) E =C +I (r1 )+G Y1 r Y r1 IS Y1

Deriving the IS curve (Loanable Funds model) (b) The IS curve (a) The L.F. model I (r ) S, I r r Y S1 Y1 r1 r1 IS

Fiscal Policy and the IS curve We can use the IS-LM model to see how fiscal policy (G and T ) can affect aggregate demand and output. Let’s start by using the Keynesian Cross to see how fiscal policy shifts the IS curve…

Shifting the IS curve: G E =Y At any value of r, G  E  Y Y E E =C +I (r1 )+G1 IS1 …so the IS curve shifts to the ____. Y1 The horizontal distance of the IS shift equals r Y r1

Exercise: Shifting the IS curve Use the diagram of the Keynesian Cross to show how an increase in taxes (T ) shifts the IS curve. E =Y Y E E =C1 +I (r1 )+G Y1 r Y r1 IS2 IS1 Y1

Facts about the IS curve The IS curve is ______________ sloped. Intuition: A fall in the interest rate motivates firms to ________ investment spending, which drives up total planned spending (E ). To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase. Changes in r lead to _______________ a given IS curve. Changes in G, T, and I _________ the IS curve.

The Theory of Liquidity Preference due to J.M. Keynes Ms & Md  r r interest rate Money Supply: Money Demand: L (r ) M/P real money balances The interest rate adjusts to equate the S and D for money:

How the Fed raises the interest rate To increase r, Fed _________ r1 L (r ) M/P real money balances

CASE STUDY Volcker’s Monetary Tightening Late 1970s:  > 10% Oct 1979: Fed Chairman Paul Volcker announced that monetary policy would aim to reduce inflation. Aug 1979-April 1980: Fed reduces M/P 8.0% Jan 1983:  = 3.7% How do you think this policy change would affect interest rates?

Volcker’s Monetary Tightening, cont. prediction actual outcome The effects of a monetary tightening on nominal interest rates prices model long run short run Liquidity Preference (Keynesian) Quantity Theory, Fisher Effect (Classical) sticky flexible i > 0 i < 0 8/1979: i = 10.4% 4/1980: i = 15.8% 8/1979: i = 10.4% 1/1983: i = 8.2%

The LM curve Now let’s put Y back into the money demand function: The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is:

Deriving the LM curve (a) The market for real money balances (b) The LM curve L (r , Y1 ) M/P r r Y LM Y1 r1 r1

How M shifts the LM curve (a) The market for real money balances (b) The LM curve L (r , Y1 ) M/P r r Y Y1 LM1 r1 r1

Exercise: Shifting the LM curve Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. Use the Liquidity Preference model to show how these events shift the LM curve. L1 (r , Y ) M/P r r Y Y1 LM1

Facts about the LM curve The LM curve is _____________ sloped. Intuition: An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market. Changes in r lead to movements ______ a given LM curve. Changes in Ms and Md _______ the LM curve.

The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: Y r LM IS Equilibrium interest rate Equilibrium level of income

The Big Picture Keynesian Cross IS curve IS-LM model Explanation of short-run fluctuations Theory of Liquidity Preference LM curve Agg. demand curve Model of Agg. Demand and Agg. Supply Agg. supply curve

Keynesian Cross IS curve basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplied impact on income. IS curve comes from Keynesian Cross when planned investment depends negatively on interest rate shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services

Theory of Liquidity Preference basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the interest rate LM curve comes from Liquidity Preference Theory when money demand depends positively on income shows all combinations of r and Y that equate demand for real money balances with supply

IS-LM model Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets.

Preview of Chapter 11 In Chapter 11, we will use the IS-LM model to analyze the impact of policies and shocks learn how the aggregate demand curve comes from IS-LM use the IS-LM and AD-AS models together to analyze the short-run and long-run effects of shocks